Commentary

Lessons from the other Facebook effect

Commentary: Internet IPO debacles affect startup investing

By

JohnShinal

WILKES-BARRE, Pa. (MarketWatch) — The drubbing suffered this year by Internet-stock buyers has begun to affect how venture capitalists invest in startups, and the trend holds a valuable lesson for retail tech investors.

The lesson, in short, is if you want to get rich on an Internet stock, either start your own company, go work for one or buy shares of another in a private-market transaction.

That’s because waiting until they hit the public markets will more than likely result in a painful hit to your portfolio, as any IPO buyer of Facebook Inc.
FB, -6.39%
Groupon Inc.
GRPN, -3.48%
or Zynga Inc.
ZNGA, -0.92%
can tell you.

Those public-market losses haven’t gone unnoticed by VCs.

The latest data released by the National Venture Capital Association shows that VCs have become more cautious about sinking money into late-stage Web startups, even as they plow more money into early-stage online companies.

Through the first nine months of 2012, investments in early-stage Internet startups surged 17% to $392.1 million from $335.5 million in the same period last year.

At the same time, investment in all Web startups was essentially flat, slipping to $1.70 billion from $1.71 billion.

The reason for this should be obvious to anyone with a set of eyeballs: While public investors who bought Facebook, Zynga and Groupon have gotten killed this year, those who got in at any point prior to the IPO have made a killing at best, and a tidy profit at worst.

Reuters

Groupon CEO Andrew Mason stands outside the Nasdaq following his company's $700 million IPO in November 2011.

Take Facebook, for example. Thanks to a rally off its September lows, the social-networking company now sports a market capitalization close to $68 billion.

The surge is small comfort to those who bought Facebook IPO shares at a valuation of more than $100 billion, as those public investors are still sitting on losses of 30%.

Not so for private investors, even those who got into Facebook relatively late.

In January 2011, more than a year before the IPO but several years after the company’s first outside investment, Facebook raised a private round from Goldman Sachs Group Inc.
GS, -1.64%
Russia’s DST and others that valued it at $50 billion.

So even after the haircut given to the company’s valuation in the public markets, those private investors are still sitting on gains of 36% six months after the Facebook IPO.

Their profits on the investment are higher than that, of course, because those firms were among the insiders and early investors selling IPO shares at $38 apiece.

Likewise, some retail investors were smart enough to wait to purchase Facebook shares after the froth had come out of the company’s valuation, and thus are sitting prettier than those unwise enough to buy the stock back in May.

Those who did the worst were those who got caught up in the IPO hype and bought the stock right away.

Best thing besides a crystal ball

While no one has a crystal ball, there’s a long body of research showing that insiders know when to sell, and that IPO shares tend to underperform the overall market for years after their debut.

For all their expertise in spotting the next big thing, venture capitalists can’t make money unless and until they convince other investors to buy a share of the startups in their portfolios at a higher valuation.

The only way to hit a home run — an investment that returns 10, 20 or 30 times an initial investment, and allows the VC firm to make money for its own investors — is to be first into a company that either executes a successful IPO or gets acquired by a bigger firm.

The later they get in to a successful company, on the other hand, the less VCs make, which helps explain why they fight so fiercely for a share of hot young companies.

Given the massive profits made by those who sold IPO shares of Facebook, Zynga and Groupon over the past 12 months — and the corresponding massive losses of those retail investors who bought those same shares — VCs are fighting harder than ever for early-stage Internet deals, even while growing leery of later-stage valuations.

While such knowledge may not help those nursing losses on these high-profile IPO dogs, tech investors would do well to remember this when 2012’s late-stage private deals become next year’s hot IPO issues.

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